Is the Black-Box Hedge Fund Model Doomed?

Hedge funds are notoriously secretive about their proprietary trading methodologies and investors have historically been OK with that. In fact, the more secretive the hedge fund and the more confounding and complicated the investment strategy, the more investors were attracted to it. After all, aren't these hedge fund guys supposed to be so smart that mere mortals can hardly understand them? Furthermore, with the advent of Artificial Intelligence, it seems that hedge funds have become so complicated that even seasoned investment professionals may struggle to explain how the investment process actually works. However, investors are finally catching on and the black-
box hedge fund model is coming under a lot of pressure today due to the following three trends:

Hedge funds on average have underperformed on a net of fees and costs basis both equities and bonds since 2000. In the very long term, hedge fund performance looks attractive. However, one can argue that hedge funds were different in the 1980s and 1990s as the industry was smaller and more nimble. The current hedge fund underperformance coupled with the steepest industry-wide fees of 2% and 20% and additional hidden costs that can be charged to fund investors make investors more likely to ask questions.

Source: Hedge fund Journal

Regulators are increasingly shining a light on what hedge funds are doing behind closed doors. From the US Dodd-Frank Act to the European AIFMD, hedge funds are required to publicly disclose more than ever. To add to this, investors have stepped up their diligence when it comes to selection and redemption criteria, and are more likely to ask for additional transparency.

Some of the leading hedge funds are willingly opening up to greater transparency and communication with their investors. For example, Goldman Sachs recently announced that it will share some of its proprietary trading strategies with investors. This does not mean that hedge fund managers must share every trade and every proprietary model they have, but they should be able to explain their investment strategy, their internal investment guidelines - including what assets they can hold, how much leverage they are allowed to take on, what concentration limitations exist, what type of volatility investors should expect, and a range of likely return expectations. Thus performance that is outside of the standard range of expectations will be questionable - both on the low and the high side.

I had a recent conversation on this topic with Amanda Tepper, CEO of Chestnut Advisory Group.

Chestnut, a consulting firm working exclusively with asset managers, conducts proprietary research into what institutional investors want from their asset managers. Chestnut’s research demonstrates that investors increasingly demand clarity and transparency around a manager’s investment strategy and operating model in order to become long-term loyal investors who are willing to withstand the ups and downs of volatile returns as long as the performance is explainable and consistent with the range of reasonable return expectations. In other words, no matter how high past returns, how hot the hedge fund and how many of your friends are investing in it, if investors cannot understand the investment and operating model, they will not invest.

Katina: Amanda, you recently published a whitepaper, Your Performance Doesn’t Really Matter – What Successful Asset Managers Do Differently. Thank you for sharing some of the findings of your research with Forbes’ readers. You’ve been working with asset managers, institutional and private investors for a long time, what did you set out to answer with your whitepaper?

Amanda: We’ve watched as the biggest asset managers continue to gain market share, and we suspected that the key drivers were not investment performance, so we conducted some research. We also reached out directly to investors to determine the key factors involved in their investment decisions. We conducted a survey of institutional investors controlling $429 billion in capital, and reviewed the investment performance and asset flow data for 931 asset managers over the past seven years.

Katina: Very interesting, so what effect did you find returns have on investors’ asset flows?